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RRSPs: Worth it in the long run?


In a previous post, I compared RRSPs with TFSAs. This time I’d like to provide a few strategies on the program Canadians are most familiar with - the RRSP. Most investors have a rough idea of how RRSPs work, but determining how they fit into your life and financial plan can be a different story.

There are two compelling reasons to invest in an RRSP. First, making a contribution helps reduce your tax bill. Often considerably! Second, any investments held in an RRSP will grow without being taxed. These advantages make RRSPs a valuable tool for growing your wealth and preparing for retirement. The caveat? The withdrawal of funds from an RRSP results in those funds being taxed as income.

Below we’ll go through the tax impacts of RRSP contributions and subsequent withdrawals. We’ll also look at a strategy I sometimes recommend when clients are unable to invest during the year.

If you’re not familiar with how contributions affect your taxes, below is a simple example for someone earning $120,000 and paying the 2019 Ontario “marginal” tax rate of about 43.0%.

Income $120,000
RRSP contribution $10,000
   
New taxable income $110,000

For this example, the tax savings on a $10,000 RRSP contribution is $4,300 ($10,000 x 43%).

On the other hand, if you’re retired and need to withdraw funds from your RRSP, your taxes will increase. For example, a person living in Ontario with an existing income of $60,000 (marginal tax bracket of roughly 30%) and withdrawing $10,000 a year from their RRSP, would incur the following:

Income $60,000
RRSP withdrawal $10,000
   
New taxable income $70,000

In this example, the additional tax on a $10,000 RRSP withdrawal is $3,000 ($10,000 x 30%).

The benefits of RRSP loans

In an ideal situation, someone wanting to invest in their RRSP will either make monthly contributions or lump sum payment(s) before the deadline. Unfortunately, this isn’t always possible.

RRSP loans are readily available for those who find themselves near this year’s March 2nd deadline (usually March 1st, or February 29th in leap years) and short of the funds they’d like to contribute.

Here are two examples of how an RRSP loan could be beneficial:

Example 1 - An investor has yet to make an RRSP contribution for the year, does not have liquid funds, but would like to make a substantial contribution while minimizing their monthly payments moving forward:

Income $120,000
RRSP loan A (1-year term) $10,000
RRSP loan B (Total payment due 90 days after loan) $7,000
   
New taxable income $103,000
  • The tax savings on $17,000 of RRSP contributions would be $7,310 ($17,000 x 43% marginal tax bracket).
  • Loan A is paid back over 12 months at $849.22/month (includes 3.5% interest). The total cost of this loan is $10,190.64.
  • Loan B is due within 90 days. It is paid off with the proceeds of the tax return at a total cost of $7,165.17 (including interest).
  • The total benefit of this strategy (vs. not making a contribution for the year) is $6,954.19 – not including growth on the investment.

Having two RRSP loans enables someone to use their tax return to eliminate one of them in short order. This allows for higher contributions without increasing their monthly costs to service the loan.

Example 2 - An investor has already made a $10,000 RRSP contribution, would like to make an additional contribution, but lacks access to additional funds:

Income $120,000
Existing RRSP contribution $ 10,000
RRSP Loan $ 7,000
   
New taxable income $103,000
  • The tax savings on a $17,000 RRSP contribution ($10,000 existing contribution plus the $7,000 loan) is $7,310 ($17,000 x 43%).
  • The $7,310 tax savings is used to pay off the $7,000 loan including $165.17 of interest accrued.
  • The total benefit of this strategy (vs. making only the initial $10,000 RRSP contribution) is $2,844.83.

Are RRSPs worth it in the long run?

A common complaint about RRSPs is that they are taxed as income when funds are withdrawn from them. It is sometimes argued this future taxation negates the current benefit.

However, most Canadians have higher incomes (and thus tax brackets) when they work, relative to retirement. As a result, they would receive larger tax returns (as a percentage of income) relative to what they’d pay on withdrawal. In other words, it would result in a net tax benefit.

However, even if someone’s tax bracket remains the same in retirement, the immediate tax savings, along with the tax-free investment growth, almost always results in a better financial result.

By no means has this been a comprehensive review of RRSPs. Rather, it is meant to provide a few helpful ideas. Lastly, as mentioned in my previous blog post, although RRSPs are usually beneficial for most Canadian investors, they may not be best suited for incorporated business owners or doctors, given the strategies that are available to them.

Feel free to contact me if you have questions about how to get the most out of your RRSPs.